Foreign Exchange

1

• Foreign Exchange
• A. Ex. rate Quotations
• 1. Direct Quote
• quoted as of M.C for 1 unit of
  F.C.(0.005/Y)
• 2. Indirect Quote
• quoted as of F.C. for 1 unit of
  M.C.(Y200/)
• 3. American quote
• expressed value of 1 unit of F.C.
• 4. European quote
• F.C. expressed value of 1

2

• B) change in foreign currency value
• (e.g. Beg. rate P4/, End
  rate P5/)
• change ( End - Beg ) X
  100
• in F.C value Beg
  
• Beg. rate .25/P,
  Ending rate .20/P
• change ( .20 - .25)
  X 100 - 20
• 
  .25
• direct quote should be used !!!

3

• C) Cross Rate Exchange rate between
  two foreign currencies.
• Ex rate for FF
  ER2.00/
• Ex rate for DM L
  1.25/
• Cross rate between FF and DM
• ER2.00/
  ER1.60/ L
• L 1.25/
• indirect quote is more
  convenient !!!

4

• Instruments in F.X.
  Market
• A) Spot contract
• Agreement to deliver or to take
  delivery of certain of F.C. immediately. (two
  biz. days)
• Spot rate ex. rate for spot contract.
• B ) Forward contract
• Agreement to deliver or to take
  delivery of certain of F.C. in the future.
• FWD rate ex. rate for forward
  contract.
• (customarily quoted in multiples of
  30 days)

5

• Key aspect of FWD contract Ex.rate for
  future delivery is to be locked in at the time
  of contract.
• e.g. Buy 90 days forward today
  for L1,000 at 1.50/L
• Is FWD rate same as future spot rate?
• F90
• F60
• F30
• S0 S30
  S60 S90

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• If Ft gt So, the currency is at premium.
• If Ft lt So, the currency is at discount.
• Annualized Ft - So X 12 X 100
• prem./disc So n
  
• n of
  months in forward rate
• (e.g. So.5000/CAN , F120 .4900/CAN)
• Annual. .4900 - .5000 X 12 X100
  -6
• prem./disc. .5000 4

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• C) Currency Swap
• When you need F.C. for certain period
  of time
• 1) borrow debt ratio will go up.
• 2) buy spot sell spot exposed to ex.
  risk.
• 3) swap exchange of currencies
  with an agreement to return same amount of
• currencies in the future.
  (usually combination of buy spot sell forward
  contract)
• Time Action
  Contract Rate
• To Buy
  Spot Spot rate
• To Sell
  FWD FWD rate

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• D) Currency Future (Chicago Mercantile
  Ex.)
• 1) Standardized size and delivery.
• 2) Impersonal contract between individual
  and the Exchange.
• 3) Marking to the Market (daily
  settlement)
• 4) speculative market because
• a.
• b.

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• E) Currency options (Philadelphia Stock Ex.)
• 1) Option buyer buys the right to buy or
  sell
• a certain of F.C. for a specified
  period of
• time at specific price (strike
  price).
• e.g. buy call option of L1000 at the
  strike
• price of 1.50/L for prem.
  .05/L with
• expiry date of June 30.
• 2) Option buyers and sellers
  expectation
• about the future spot rate is
  opposite.

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How to use F.X. Market

• A) Settlement of intl trade foreign debt by
  transferring purchasing power.
• B) Speculation by using one of the instruments
  available in the F.X. market.
• (e.g. spot, forward, future and options.)
• C) Arbitrage
• 1. Two point arbitrage (locational
  arbitrage)
• Temporary disequilibrium among the
  regional banks make this possible.
• Bank A Bank B
• Bid (bank buy) 1.9999/L
  2.0001/L
• Ask(bank sell) 2.0000/L
  2.0002/L

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• 2. Three point arbitrage (triangular
  arbitrage)
• A temporary disequilibrium among the
  different F.X. markets makes this possible.
• New York 1 ER 1.5
• London ER1 PS 5
• Tokyo PS 6 1

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• 1)Can we do three point arbitrage ?
• MKT vs.EQ cross rate
• Mkt cross rate ER1.00 PS 5.00
• Eq. cross rate PS 6/1 ER1.50/1
  PS 4.00 ER1.00
• Since there is a discrepancy between the
  market rate and equilibrium rate, we do have a
  chance to do triangular arbitrage.
• 2)Which route to take ?
• If multiplication of conversion rates gt 1
  --- , the route is profitable .
• NY-- LD--TK 1.5x5x 1/6 1.25---correct
  route
• TK-- LD-- NY 6x1/5x1/1.5 0.88---
  incorrect route

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• D) Hedging
• A transaction in FWD market designed to
  minimize potential loss from ex. rate
  fluctuation.
• E.g. US co. exports L1000 product to UK
  w/ 90 days credit.
• Options
• 1) do nothing (sell at future spot)
  earning
• S90 (90days future spot rate) 1.60/L
  1,600 (expected)
• 2) hedging (sell 90 days forward)
• F90 (90 days forward rate) 1.50/L
  1,500 (fixed)
• Most of the international traders prefer
  hedging since they are risk averters and want to
  minimize the risk from exchange rate fluctuation.